Contested Capitalism

Richard W. Carney

• Publisher: Routledge
• Year: 2009
• ISBN:
  9781135245368
• Edition: 1
• Topic: Politics & International Relations
• Subtopic: Politics
• Index: Politics & International Relations

This book examines the political origins of financial institutions across fifteen developed democracies, with focused case studies on the US, France, Japan, Austria, and Germany.

The institutional arrangements of financial systems are widely seen as a central distinguishing feature of 'varieties of capitalism'. Through a wide-range of case studies, this book contends that political battles between landed interests, labor, and owners of capital have fundamentally shaped modern financial arrangements. Demonstrating how these conflicts have shaped contemporary financial architecture in a number of different contexts, author Richard W. Carney offers an innovative approach to explaining the distinctive capitalist arrangements of nation-states. By demonstrating the importance of landed interests to nations' institutional configurations, the book has clear implications for developing countries such as India and China.

Providing a detailed account of the development of financial institutions, this book will be of interest to students and scholars of political science, sociology, business, finance, and law. It will also offer insights valuable to government policymakers, analysts at international organizations, and the business community.

Part I
Questions and explanations

1 Introduction

Why do advanced democracies have such different financial systems? For example, why have the US and UK relied so much on equities markets during the past century, while other countries, such as Germany and Japan, have relied more on bank-based financial arrangements? And why do financial systems change, sometimes dramatically and quickly? For example, the French and Japanese financial systems exhibited many surprising similarities to the contemporary United States before World War II; after the war, they went through radical transformations.

Understanding the structure of national financial systems has attracted attention from across the social sciences in the past decade for two main reasons. First, research has clearly linked economic growth to financial development: the more developed a nation’s financial system (i.e., the more sophisticated a nation’s capital markets and banking services), the more economic growth it generates (King and Levine, 1993a, 1993b; Levine, 1997, 1998; Levine and Zervos, 1998; Rajan and Zingales, 1998; Levine et al., 2000). Second, the structure of national financial systems is a central distinguishing feature of national varieties of capitalism – coordinated market economies (CMEs) and liberal market economies (LMEs) – which support specific kinds of strategies on the part of firms in international markets. In CMEs, equities markets are less important than in LMEs for firm financing (Hall and Soskice, 2001).

The dominant view to explain differences among financial systems is the legal origins perspective (La Porta et al., 1998, 2008), which argues that contemporary levels of financial development are largely determined by a country’s legal tradition; British common law provides better protection to minority shareholders and hence leads to larger financial systems (and equities markets) than civil law. However, alternative political economy explanations have emerged that emphasize the role of political institutions and/or interest groups. The political institutions view suggests that financial development depends on how political institutions mediate conflicts of interest over the security of property rights which then affects the structure of the financial system (e.g., Verdier, 2003; Acemoglu et al., 2004; Lamoreaux and Rosenthal, 2005; Acemoglu and Robinson, 2006; Haber et al., 2007). Interest group explanations take a step back in the causal chain by focusing on the preferences of specific actors and the political coalitions they may form (e.g., Rajan and Zingales, 2003; Roe, 2003; Gourevitch and Shinn, 2005). Both perspectives have merit: allow political institutions to vary while holding actors constant and financial outcomes will vary accordingly; the converse is also true.

This book begins with the premise that institutional inertia has shaped modern financial arrangements in ways that cannot be accounted for by looking solely at contemporary political cleavages or institutions. To understand the causal mechanisms that have produced modern financial arrangements it is necessary to examine the origins, and to consider which actors were most important at that time. But in those moments, not only were new bargains struck over the design of financial institutions, often political institutions were also restructured, as in many countries following World War II (e.g., France, Germany, Austria, and Japan). For this reason, this study places greater emphasis on actors and coalitions.

By looking back to when bargains were struck over the design of modern financial institutions among advanced democracies, it becomes clear that landed interests (farmers) have had a substantial, though frequently overlooked, impact. As a result, this book argues that political battles fought between landed interests, labor, and owners of capital at formative moments in a nation’s institutional development have substantially shaped modern financial arrangements. The resultant financial institutions depend upon which actors formed a winning political coalition at that moment. When these battles occur in the wake of a crisis that leads to new political institutions, dramatic changes to the structure of financial institutions are possible; when in the context of pre-existing political institutions, financial outcomes are constrained. The details of the argument are presented in Chapter 2.

This argument differs from the alternatives highlighted above with its focus on the origins of contemporary financial institutions, as well as with its focus on farmers as a key actor. It shows that farmers have had a substantial impact not only on national banking systems, but also on corporate ownership and equities markets. Further, the study clearly demonstrates that financial arrangements really were different before World War II in many advanced democracies, and offers a parsimonious explanation for the variety of financial arrangements observed across space and time. In contrast to many other studies which emphasize the causal role of political institutions, I see the actors as critical – particularly at those moments when both financial and political institutions change. Once new political institutions are in place, they preserve and bias the evolutionary path of the financial system. This is consistent with Acemoglu and Robinson’s (2006) argument that political institutions enable credible commitments to new bargains; but the key causal mechanism is the de facto power that groups wield when the new institutional bargains are struck (as opposed to de jure power, which is granted by the institutions). A final contrast with the aforementioned arguments is with this book’s focus on general financial characteristics. That is, financial institutions are seen as complementing one another, and arising from a common political origin.¹ Like varieties of capitalism, financial systems fall along a continuum: at one end, financial institutions complement one another in generating incentives for actors to focus on the short term, as in LMEs; at the other end, financial institutions foster a longer term focus, as in CMEs.² The “patient” capital of CMEs allows employment to be more stable and longer term, and enables workers to devote more of their time and energy to cultivating job-specific skills.³ In this way, financial arrangements complement industrial relations, vocational training, and other dimensions of capitalist systems. Indeed, the varieties of capitalism literature points to the reliance on equities markets and related corporate governance rules as central distinguishing features of capitalist ideal-types. As a result, understanding the origins of financial institutions offers insight into how national varieties of capitalism have emerged and persisted.

Which financial institutions?

To understand how interests impact the structure of the financial system, I focus on four dimensions: the diffusion of corporate ownership, the extent of government intervention via banks, the agricultural bias of the banking system, and the public or private orientation of pension funds. Each of these dimensions has had a substantial impact on the mobility of capital within wealthy economies during the last century. The benefit of looking at this diverse array of financial arrangements is that they each perform different functions, and so taken together they offer a holistic view of a country’s financial system as well as a broad assessment of how easy it is to move money from one place to another.

Capital which can easily move between investments generates stronger incentives to focus on short-term results, and ultimately affects how economic actors behave and interact with one another. For example, in the United States, firms frequently turn to the equities market to raise money. This entails selling ownership rights in the firm to a diffuse group of shareholders, which generates a collective action problem in monitoring the firm closely – the Berle–Means (1932) problem of the separation of ownership and control. To compensate for this, managers’ compensation packages are closely tied to the firm’s share price via stock options, and the firm must provide quarterly earnings updates (among other mechanisms to ensure managers’ incentives are aligned with those of shareholders). If the firm fails to meet investors’ expectations, investors will sell the company’s shares. As a result of these performance updates every three months, firms focus their strategy on meeting, if not exceeding, these expectations. If a firm faces difficulties, cost cutting via layoffs is a common first (and last) line of defense. As a result of these uncertain employment prospects, workers’ incentives to acquire firm-specific skills are diminished. But when firm ownership is concentrated among a handful of owners, there is less reliance on using the share price as a quick measure of the company’s performance since the owners have the incentive to monitor the firm closely. If necessary, they have the power to intervene. As a result, there tends to be less pressure on meeting quarterly earnings expectations, and a stronger orientation on the long-term competitiveness of the firm. We can then see how diffuse or concentrated ownership generates incentives to focus on the short or long term. One consequence of this tends to be a greater reliance on equities markets in those countries where diffuse ownership is more common, and money quickly moves in and out of the market. The converse of this is that bank lending tends to be more important as a source of external financing in countries with more concentrated ownership (since selling shares would diminish the power of the owners). Money thus tends to be tied up for a longer period of time.

Other dimensions of a nation’s financial system likewise affect the speed with which money flows around the economy. For example, the extent of government intervention in the economy via banks can have a substantial impact when the government intervenes in the economy to decide how money gets lent (as part of the economy’s regular functioning rather than when the government intervenes on a temporary basis as during a crisis). The greater the level of government intervention in the economy, the more important bank lending becomes, which diminishes pressure to meet short-term expectations as would occur if firms were otherwise selling equity stakes to diffuse shareholders. Because government intervention via banks has played an important role in the structure of national financial arrangements over the past century, this is another key dimension examined in this book.

A third important dimension is the agricultural bias of the banking system. Often there is overlap between this dimension and government intervention since banks that cater to the agricultural sector are often owned by the government. However, banking regulations can arrange for the diversion of financing to the agricultural sector without government ownership of banks, as with interstate bank branching regulations in the United States (Calomiris, 2000; Rajan and Ramcharan, 2008). In either case, banks assume a larger role in handling the nation’s stock of capital, and prevent money from flowing to corporations via the equities market. Agricultural banks, such as France’s Crédit Agricole or Japan’s Norinchukin Bank, became some of the largest financial institutions in the world during the past century, and have had a substantial impact on the structure of national financial arrangements as a result.

The final dimension of financial systems considered in this study is the public/private orientation of pension funds. A heavier reliance on public pensions means that less money will be available for investing in private companies via the equities market. Investing public pension fund money in a nation’s equities market is a political minefield (choosing which equities to invest in can lead to charges of corruption, not to mention that equities markets generate volatile returns), so public pension funds avoid this, and instead invest in more politically neutral and less risky assets such as government bonds. But private funds do go into equities markets since they are not constrained by politics. As a result, the more heavily a nation relies on public pension funds, the less money is available for investing in private companies via the equities market.⁴

Together, these four dimensions offer a broad depiction of the way national financial systems have been organized during the past century. Each dimension involves a trade-off that affects how easily money can be moved from one investment to another, with consequences for the long- versus short-term incentives that economic actors face. Concentrated ownership, high levels of government ownership of banks, extensive support for agricultural banking, and public pensions tend to foster investments that are more specific, and thus longer term, which in turn generate longer term incentives in other areas of the economy.

While asset specificity (and its related short- vs. long-term effects) is widely recognized as a defining attribute of different capitalist systems, Peter Hall and David Soskice suggest that government intervention and the size of the agrarian sector could also be important distinguishing attributes of Mediterranean (or mixed) economies, such as France, Italy, Spain, Portugal, Greece, and Turkey (Hall and Soskice, 2001: 21). In this regard, looking at the structure of the financial system is particularly helpful since it can accommodate these additional characteristics while, at the same time, accounting for asset specificity. Government intervention in the economy is straightforwardly reflected in the structure of the financial system by the extent of government ownership of the nation’s banks. Indeed, economists point to government ownership of banks as a, if not the, critical mechanism by which government intervention in the economy takes place.⁵ The importance of the agrarian sector is also reflected in the structure of the banking system. A larger agrarian sector generally requires a greater number of local credit institutions, so the number of these and the size of financing directed to the agricultural sector reflects its importance. Thus, an examination of the financial institutions that correspond to the extent of government intervention and the importance of the agrarian sector, in combination with asset specificity, offers a robust depiction of how the financial system mirrors different varieties of capitalism.

The existing literature

As discussed in the opening section, national financial arrangements are frequently explained with reference to one of three dominant perspectives: the country’s legal tradition, interest groups, and political institutions. I begin this section with a brief overview of arguments from each approach. I then turn to a brief summary of the varieties of capitalism literature and how this study contributes to it. Finally, I discuss how my argument fits with respect to the dominant interest group explanations found in political science.

Following the “law and finance” initial emphasis on minority shareholder protections (La Porta et al., 1998), much of the recent literature on financial institutions has focused on corporate governance.⁶ Roe (1994), however, offers an excellent illustration of how different facets of the financial system are closely linked, and the wide-ranging impact of interests that wield political influence. He focuses on the political influence of populist interests within the context of a federal political system to explain the development of America’s fragmented financial arrangements. His analysis clearly illustrates that an array of financial institutions owe their design to a shared political source. Allen and Gale (2000) further demonstrate that such complementary financial arrangements are not specific to the US, but are common to many countries. And in work since La Porta et al.’s 1998 paper, other attributes of financial systems have been examined for their relationship to the country’s legal tradition (La Porta et al., 2008). Taken together, these perspectives suggest that there is promise in developing a theory that roots national financial arrangements in a common political origin.

Rajan and Zingales (2003) also emphasize the impact of political interests in a cross-national and historical study of financial development (where more robust securities markets correspond to more financial development). They argue that entrenched businesses lock up access to domestic finance via their political influence, but domestic capital markets do grow, and allow entrants access to finance, as the entrenched firms turn to lower cost financing from international capital markets when trade and capital flows increase. Roe (2003), by contrast, emphasizes political ideology in affecting the diffusion of corporate ownership; where social democracy is weaker, corporate ownership becomes more diffuse and a greater emphasis is placed on meeting shareholders’ short-term earnings objectives. Pagano and Volpin (2005) and Perotti and von Thadden (2005) likewise argue that poor shareholder protections correspond to strong employment protections. Gourevitch and Shinn (2005) build on this perspective by considering the outcomes that occur when labor interacts with owners and managers in the political arena, and the manner by which political institutions mediate interactions between these groups.

Interest group arguments have also become increasingly prominent among authors who focus exclusively on the structure of the banking system (and how much it caters to the agrarian sector; e.g., Calomiris, 2000; Rajan and Ramcharan, 2008), government intervention (e.g., Glaeser and Shleifer, 2003), and pension funds (e.g., Baldwin, 1990; Perotti and Schwienbacher, 2007). Given the wide-ranging impact that interests can have on the structure of financial institutions within a single country, as Roe (1994) convincingly demonstrates for the United States, these other studies further suggest that there is promise in developing a general interest group theory to explain financial arrangements across countries.

Other authors emphasize the role of political institutions. For example, Verdier (2003) argues that state centralization facilitates the growth of capital markets by drawing savings out of the interior and channeling them to large industrial enterprises in urban centers. Pagano and Volpin (2005) emphasize the role of electoral systems: owner-managers and workers converge on a political platform featuring low investor protection if the voting system is proportional but not if it is majoritarian. This is mirrored in Gourevitch and Shinn’s (2005) analysis which encompasses a broader set of consensus versus majoritarian attributes. The chapters in Haber et al. (2007) investigate a wide range of political institutions across countries and time, and convincingly illustrate their important role in shaping financial arrangements.

Among the advanced democratic nations, which this study focuses on, the varieties of capitalism approach has gained wide appeal for its characterization...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Illustrations
• Preface
• Part I: Questions and explanations
• Part II: Broad patterns
• Part III: Cases
• Part IV: Conclusions
• Notes
• References